Staff Reports
Bank Leverage Limits and Regulatory Arbitrage: Old Question, New Evidence
Previous title: “Leverage Limits and Bank Risk: New Evidence on an Old Question”
Number 856
June 2018 Revised December 2019

JEL classification: G20, G21, G28

Authors: Dong Beom Choi, Michael R. Holcomb, and Donald P. Morgan

Banks are regulated more than most firms, making them good subjects to study regulatory arbitrage (avoidance). Their latest arbitrage opportunity may be the new leverage rule covering the largest U.S. banks; leverage rules require equal capital against assets with unequal risks, so banks can effectively relax the leverage constraint by increasing asset risk. Consistent with that conjecture, we find that banks covered by the new rule shifted to riskier, higher yielding securities relative to control banks. The shift began almost precisely when the rule was finalized in 2014, well before it took effect in 2018. Security-level analysis suggests banks actively added riskier securities, rather than merely shedding safer ones. Despite the risk-shifting, overall bank risk did not increase, evidently because the banks most constrained by the new leverage rule significantly increased leverage capital ratios.

Available only in PDF
AUTHOR DISCLOSURE STATEMENT(S)
Dong Beom Choi
I am employed by the Federal Reserve Bank of New York. The views expressed in the article under submission reflect my views and the views of my co-authors, but do not necessarily represent the views of the Federal Reserve Bank of New York, Federal Reserve Board, or the Federal Reserve System.
I have not received outside financial support for the research in this article.
I have not received any fees or payments from any institutions that might be relevant to the content of the research under submission.
No close relative has received funding or financial support, or is an officer, director, or board member of any relevant organization.
The article was vetted prior to circulation outside the Federal Reserve Board and the Federal Reserve Bank of New York.

Michael R. Holcomb
The author declares that he has no relevant or material financial interests that relate to the research described in this paper.

Donald P. Morgan
I, Donald P. Morgan, have no relevant or material financial interests that relate to the research described in this paper.